Finance and Trading Terms Explained: What Is Reflation?

Whether you've never heard of it or just need a refresher, we've got the lowdown on this financial term.

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Even professional traders and investors can't always speak the language of colleagues working in a different segment of the financial world. With that in mind, we've introduced this weekly column, looking at one esoteric or potentially misunderstood finance or trading term every week. After bringing you "carry trade" and "contango" in past columns, we'll now focus on "reflation."

What Exactly Is Reflation?

As Michael Gayed of Pension Partners explains it, "Reflation is the process of restoring inflation to its long-run historical average, and can be considered a cure to potential deflation."

Darryl J. Poisson, Founder and President of DJP Wealth Management, adds that reflation is an attempt to "reduce the natural economic contraction -- or reignite the business expansionary cycle -- which invariably follows a significant expansion."

This can be done through monetary policy -- central banks may increase the money supply, lower interest rates, and/or ease bank reserve requirement -- or federal fiscal policy changes that lower taxes or loosen business regulations. All of these efforts are taken to increase the amount of money flowing through the economy and instill confidence in consumers and market players.

For example, let's say that inflation is trending at 2.5% in one year, and in the next year, deflationary pressures bring that rate to 0%. The year after that, the US government and Federal Reserve would introduce policies to raise the rate of inflation back to the long-term trend line (2.5%). Because this inflation represents a return to the long-term trend, it is considered to be reflation.

Where Does the Word "Reflation" Come From?

According to Michael Greaney, Director of Research at the Center for Economic and Social Justice, the word reflation was introduced after the stock market crash of 1929 and coined by Irving Fisher, the neo-classical economist most remembered for his Quantity Theory of Money (QTM) equation. Before the crash, Fisher had been predicting that the American stock market had reached a level of permanent prosperity -- a "permanently high plateau." Even after Black Tuesday and the onset of the Great Depression, Fisher insisted that "security values in most instance were not inflated."

To Fisher, the major problem was deflation -- a lowering of prices caused by a decrease in the money supply. In order to avoid saying that the solution to deflation was inflation, which nevers sounds like a good thing, he came up with the term reflation. In the name of reflation, Fisher advocated that the government bring prices back to their pre-crash levels by creating debt-backed currency, therefore increasing the money supply and restoring consumer and investor confidence.

Reflation policy has been used by American governments to try and restart failed business expansions since the early 1600s. Although almost every government tries in some form or another to avoid the collapse of an economy after a recent boom, none have ever succeeded in being able to avoid the contraction phase of the business cycle. Many academics actually believe government agitation only delays the recovery and worsens the effects.

So reflation is an effort to artificially bolster business expansions, but it has never managed to fully reverse a contraction. For this reason, it can be a pretty contentious issue.

How Can Investors Benefit From Reflation?

To answer the question very broadly -- equities.

In general, stocks fare well during periods of reflation because reflation is always a response to deflationary pressures, which typically send stocks down to bargain-price levels. "As central banks and the government then work towards stimulating the economy, reflation from those efforts results in a healthier environment for stock risk taking. Reflation expectations tend to be the turning point for a downtrend in equities, and bring with them the potential for heavy gains in the initial period of price level recovery," Michael Gayed told us.

In addition, bond funds can also be a solid investment choice as the price of bonds rise as interest rates are lowered.

QE lowers interest rates and increases the money supply, both tactics used for reflation, but do QE and our word of the week actually go hand in hand?

According to David Stein, Founder of Darby Creek Advisors, "Quantitative easing, at least as practiced by the Federal Reserve, does not increase the money supply directly. All that newly created money sits in the banks' excess reserve accounts."

However, the effects of QE are reflationary, or at least, are intended to be. As Stein says, "They [members of the Federal Reserve] are trying to put downward pressure on interest rates by reducing the supply of Treasuries, forcing investors to reach for yield and purchase stocks. The resultant equity boom is supposed to make us feel wealthier and more inclined to borrow money, thus ultimately increasing the money supply as banks lend more."

It has a reflationary effect, says Stein, adding that "QE is more a psychological game central banks play."

Editor's Note: This story orginally stated that David Stein is the Chief Investment Strategist and Chief Portfolio Strategist at Fund Evaluation Group. Stein no longer works at Fund Evaluation Group.